SPECIAL FOCUS: CAPITAL MARKETS OUTLOOK 2008

APARTMENT FINANCE TODAY • JANUARY 2008

Crisis of Confidence?

Multifamily dealmakers foresee volatile rates, tougher terms, and lower values for some properties.

By Andre Shashaty

Asking real estate professionals what they think about the capital markets outlook for 2008 is like giving a Rorschach test to a manic-depressive. On a good day, the capital market upheavals that started in 2007 look like a bump in the road, but on a bad day, they look like an icy crevasse.

While the fundamentals of supply and demand for apartments are positive and likely to get even better in 2008, the problems with defaults and foreclosures on home mortgages have not ended, and may get worse. The ripple effects have proved far more potent than most people expected last fall, and could continue to work through the entire real estate finance system like a cancer.

As 2007 ended, owners, developers, and lenders who had not relied on securitized financing felt pretty good about the outlook for 2008. They were no longer losing tenants en masse to homeownership, and plenty of capital was still available. As one financier told APARTMENT FINANCE TODAY, “Banks and insurance companies are kicking butt, and rates are under 6 percent; it’s a great time.”

Fannie Mae, Freddie Mac, banks, and insurance companies had been picking up the slack left by the Wall Street conduit lenders who had largely stopped originating loans in the fall. The cost of debt had only increased slightly thanks largely to the decline in the benchmark 10-year Treasury rate, which is used as the basis for pricing many permanent loans.

For 2008, the optimists said they expect capital sources will charge a bit more and lend a little less on average, and that capitalization rates will go up for everything but the creamof- the-crop deals in the best markets. They described this scenario as a return to normal underwriting and valuations after several years of aggressive underwriting that fueled high-leverage deals by the hundreds.

But several other shoes will be dropping in 2008. First, the home lending crisis is going to get worse, with home mortgage delinquencies and foreclosures not expected to reach their peaks until late this year, according to a survey by the Mortgage Bankers Association.

Second, it is unlikely that Fannie Mae, Freddie Mac, and other sources can fill the credit gap left by the conduits completely. Demand for multifamily properties could decline as would-be buyers fail to find the financing they need to close deals.

Third, a radical decline in the value of single-family homes could “trickle up” to multifamily properties.

“Value percolates up from the bottom,” said Rich Kelly of LumaCorp, Inc., in Dallas. “If the whole housing trade-up process stops, it ripples all the way up.” He said a lot of property buyers in Texas are people doing exchanges out of California, trading four-plexes for larger buildings in Texas. If they cannot finance that four-plex, then the pool of entry-level apartment buyers dries up. “I can definitely see that happening,” he said.

Panic on Wall Street

The volatile forces affecting the multifamily industry were unleashed in early 2007, when the first widespread problems were found with subprime loans made to homebuyers who had poor credit ratings, as well as no-documentation loans and loans with low introductory rates. The problem was compounded by interest rate hikes that drove up rates on adjustable-rate loans.

By late summer, Wall Street firms were having trouble selling securities backed by single-family mortgage loans. Commercial mortgage-backed securities (CMBS) quickly fell out of favor too, as investors fled from the perceived risk of real estate to the safety of U.S. Treasury bills.

By December, it was clear: The high-flying investment bankers who made massive fees securitizing commercial real estate finance had done a face-plant and would recover slowly, or in some cases, not at all. The days of full-tilt profit-taking from overaggressive lending with no consequences had ended with a thud.

As Robert White, president of Real Capital Analytics, put it, “Investors lost confidence in what Wall Street was selling.” The investment bankers have to win that confidence back, he added. That will involve taking a hard look at a system where lenders make loans only to earn loan origination fees, with no stake in the success or failure of the loan after it is securitized. (For details on the conduit lending picture, see Conduit Lending Falls Off the Table .)

Conduit lenders had provided more and more generous loans for properties in middle markets, often with high loan-to-value (LTV) ratios and low rates, and recently, requiring no amortization of principal.

The absence of conduit lenders from the marketplace mostly hurts borrowers with deals in marginal locations where Fannie and Freddie don’t want to do business and those borrowers who relied on high leverage, APARTMENT FINANCE TODAY’s sources said.

While many borrowers will be able to find financing by switching to Fannie Mae, Freddie Mac, banks, or insurance companies, they will face some obstacles, AFT’s sources said. For one thing, Fannie and Freddie will be busy, and newcomers will find it hard to get fast action on their deals. They will also face tighter underwriting and lower loan proceeds.

“Underwriting standards have tightened, placing more emphasis on current net operating income and reducing proceeds to more conservative levels, [such as 60 percent to 65 percent of value],” said Lilli Dunn, senior vice president for investments at AvalonBay.

“Loan sizing for acquisition debt will be more restrictive, and spreads have already widened. The illiquidity in the CMBS markets dictated this, and tightening loan standards will ultimately impact asset pricing,” said Samuel “Trip” Stephens, chief investment officer of ZOM, Inc.

Fannie and Freddie were giving their good customers up to 80 percent of value, but Kelly of LumaCorp said it was a lot tougher to obtain a loan for that high a percentage of value. He said that 70 percent to 75 percent is becoming the norm.

On the construction side, Stephens predicted that debt coverage ratios and spreads would continue “creeping up.”

Construction loans will be offered by fewer banks, and their standards will be higher, added Tom Bozzuto, president and CEO of The Bozzuto Group. “I expect it to be tough to get construction loans,” he said.

White agreed that development will be hard to finance in 2008.

Rates holding steady

The real estate credit crunch drove up pricing for permanent apartment loans in 2007. Interest rates on loans are usually calculated using the yield on the 10-year U.S. Treasury bill as an index and adding on top of that a “spread” measured in basis points, each of which is 1/100th of a percentage point.

The yields required to sell CMBS shot up last fall, and by December, conduits were quoting rates on new permanent loans at about 300 basis points over Treasuries.

Loans from Fannie and Freddie were a bargain compared to conduit loans last December, an advantage that is likely to continue well into 2008. From a low of 135 basis points over Treasuries, loan pricing spreads crept up to around 170 basis points in December for quotes on 10-year money.

At press time, Fannie was pricing “very competitively,” said Howard Smith of Green Park Financial, which expected to do $1.2 billion in multifamily Fannie deals in 2007, 30 percent of it in December. The 2007 total is up from $1 billion in 2006.

He said that underwriting had been relatively steady and that loans were being made in December at 180 basis points over the 10-year Treasury, which would amount to a 5.7 percent loan rate.

The wild card is what happens to the 10-year Treasury rate. At the start of December, it had fallen to 3.9 percent. But AFT’s sources did not expect it to fall further in 2008 unless there was a recession.

Stephens said chances are good that Treasury rates will rise to a range of 4 percent to 4.5 percent in 2008. He said agency debt would then be in the high 5 percent to low 6 percent range, “which will still be attractive to many leveraged buyers.”

Many sources said they expect spreads to stabilize or even decline a bit this year as the capital markets settle down. If that occurs, and there is only a slight increase in 10-year Treasury yields, the actual interest rate on most loans will remain steady or rise only slightly.

Dunn predicted that, as the CMBS market settles down, increased liquidity should provide some spread reduction by this spring.

One thing that most sources agreed on is that there will be continued volatility in loan pricing in 2008. “Spreads are still highly inconsistent and can change between application and rate lock based on market volatility,” said Dee McClure, senior vice president at CWCapital.

She said borrowers are looking for more predictability by turning to the one lending source that is somewhat immune from the capital markets craziness: the Federal Housing Administration (FHA). “In today’s market, the predictability of FHA underwriting criteria is now highly prized as the programs continue to provide high leverage (up to 85 percent LTV on existing properties and 90 percent of cost on new construction) with accompanying low debtservice coverage ratios, with 35- to 40-year amortizations.”

One of the big unknowns is how commercial banks will react to the changing economy. At press time, many banks were still eagerly making three- to five-year mini-perms and construction loans on good terms.

But several sources suggested the banks are walking a fine line between wanting to do business and wanting to play it safe.

Some lenders will pull back, particularly those that are overexposed to the single-family sector, said Stephens of ZOM. On balance, the regional banks should still be active multifamily construction lenders, and foreign banks should also remain active, given the weak U.S. dollar, he added.

The most active banks generally don’t have exposure to the subprime home loan problems or the shaky market for CMBS.

Equity demanding higher returns

The reduction in loan proceeds is putting more pressure on the equity and mezzanine side of the equation, with rising demand for these products translating into higher costs to owners and developers.

As equity sources are requiring higher returns, mezzanine lenders have raised their rates, said Peter Donovan, senior managing director at CB Richard Ellis Capital Markets. Some equity investors have moved into the mezz lending business, he added.

The National Multi Housing Council Equity Finance Index, which reflects its members’ view of the availability of equity capital, dropped to 22 in a quarterly survey conducted in October, the lowest figure on record. That means that more than half of respondents (56 percent) said equity capital was less available than it was three months earlier.

Cap rates were headed upward at the end of 2007, and were expected to rise the most for Class B and Class C properties in secondary and tertiary markets.

Investors are asking more questions about economic viability, said White. “Recession or no recession, they have scaled back assumptions on rent growth and occupancy.”

Some equity players are trying to get higher returns, added Linwood Thompson, who heads the multifamily operation at Marcus & Millichap. He said equity capital sources are demanding buyers show how they can deliver higher exit cap rates and are increasingly skeptical of income estimates based on aggressive projections for how high and how fast rents can be increased.

On a positive note, international investors are expected to show an increased interest in U.S. multifamily properties in 2008.

Recession, inflation, or both?

Most economists were predicting that U.S. economic growth would slow in 2008. The question was whether it would slow enough to qualify as a recession.

“If we can skirt a recession, the problems will remain isolated in securitized financing, and liquidity will return. If there is a recession and rents falter, and we see delinquencies, it will feed on itself,” said White. “Right now, we do not have loan delinquency problems. Cash flow is there,” he said.

Some lenders and owners are worried that the Federal Reserve Board’s cure may be worse than the disease. They are concerned that further cuts in the federal funds rate could ignite fears of inflation and drive interest rates up substantially.

“My biggest concern is that the short end of the yield curve is kept low to avoid recession while global demand for commodities drives inflation higher,” said Todd Sears, vice president of finance for Herman & Kittle Properties, Inc., in Indianapolis. “The net result being a sharp long-term rise in the 10-year [Treasury bill]—and that ultimately raises equity yield requirements, too.”

Commercial real estate is headed for some rough sledding. Moody’s Investors Service reported that prices fell an average of 1.2 percent for office and retail properties in September. Bloomberg News was quoting analysts as saying a bubble in commercial real estate pricing was about to burst and that the market was “imploding.”

Of course, multifamily owners and lenders believe their sector is still “a preferred asset” because it’s thought to be less affected by recessions and to benefit from the government-sponsored enterprises’ commitment to help provide liquidity for housing.

They may be right. Brookings Institution Senior Fellow Tony Downs believes that greed will trump fear and that capital providers will feel compelled to come back to real estate rather than seek other investments, such as the stock market.

The fundamentals of apartment supply and demand are excellent, with immigrants and the echo boomers both among the fastestgrowing demographic groups. The newfound restraint among capital providers likely will help keep the fundamentals healthy.

For Dunn, at AvalonBay, the future is uncertain, but not bleak.

“Given the current tight spreads and a repricing of risk, capitalization rates are projected to increase, but the timing and degree is debated,” she said. “The trend of broad-based capitalization rate compression should reverse, and differentiation across asset and location quality should become more apparent. However, a reversion back to the long-term average is not expected, and a dramatic outflow of capital is not projected.”

Dunn cited as support for her view “the deep and diverse pool of capital and the appeal apartments offer from their current income nature and relative risk-adjusted return compared to alternative real estate investments; improving fundamentals partly fueled by attractive demographic and immigration projections; and investor acceptance of apartments as a core asset class.”

If the capital markets were entirely rational, those arguments would suggest multifamily will do reasonably well. But capital markets are not completely rational, and the people who make the collective decisions about where to place money have plenty of reasons to be scared.

While President George W. Bush put forth a plan to deal with the home mortgage crisis in December, the mere fact that he felt a need to step in to tell banks how to deal with bad loans was an admission of the severity of the problem. Press coverage of the markets that week suggested that housing was entering its biggest slump since the Great Depression.

In an only slightly less scary assessment, Moody’s said, “The current housing recession is expected to run through early 2009 and will ultimately be severe enough to be characterized as a housing crash.”

“Of most concern is that sliding house prices and eroding mortgage quality will reignite another wave of global financial turmoil. The ramifications of this for the economy, and thus housing, would be overwhelming,” the Moody’s report added.

That’s why savvy players will be watching the numbers from the banks and from Wall Street at least daily, if not hourly. The financial system still has exposure to hundreds of billions in mortgage losses that are yet to come, and there could be shock waves each and every time a major institution reveals its true losses.

They will also be watching real estate investment trust (REIT) stock prices. In early December, AvalonBay was trading at $105, down from its 52- week high of $150, and it was not alone. Other apartment REITs have suffered a vote of no confidence from investors regardless of the soundness of their fundamentals.

If you think the problem with home loans should not affect apartments, which have no big problems with delinquencies or high-risk loans, forget it. As one executive with a publicly traded real estate finance firm that has no home mortgage exposure told AFT after a conference call with Wall Street analysts, “We are all getting hammered.”